Discount to Fair Value Calculation

When it comes to value investing, estimating a stock’s fair value (also known as intrinsic value) is crucial. Our stock screeners use the Discount to Fair Value metric to quickly identify potentially undervalued stocks. This guide explains how this metric is calculated using two approaches: Free Cash Flow and Net Profit.

The Discounted Cash Flow (DCF) Method

The Discounted Cash Flow (DCF) method is a fundamental approach to estimating the value of a business based on its expected future cash flows. This technique involves the following steps:

1. Projecting future cash flows, including a terminal value
2. Discounting the projected cash flows back to their present value using a specified discount rate

The core principle behind DCF is that the value of money decreases over time, making future dollars less valuable than present ones.

Free Cash Flow and Net Profit Approaches

Our stock screeners use two approaches to estimate the fair value of a stock:

1. Free Cash Flow: This approach focuses on the actual cash generated by the company, reflecting its financial health and operational efficiency.
2. Net Profit: This approach looks at the company’s profitability and earnings power, indicating its ability to generate income.

By using both approaches, we gain a more comprehensive view of a company’s financial position.

Approach 1: Free Cash Flow

1. Determine Historical Growth Rate: We calculate the historical free cash flow growth over the last 10, 7, 5, and 3 years and select the longest available period.
2. Apply Growth Rate Cap: To maintain a conservative estimate, we cap growth rates exceeding 20% per annum at 20%, recognizing the challenge for businesses to sustain high growth rates over extended periods.
3. Project Free Cash Flow: We project the current free cash flow per share over a 10-year horizon using the selected growth rate.
4. Calculate Terminal Value: We apply a terminal Price to FCF ratio of 15 to calculate the terminal value at the end of the 10-year period.
5. Discount to Present Value: We discount both the projected free cash flows and the terminal value to the present day using a 12% discount rate, consistent with the default discount rate in the Intrinsic Value Calculator.
6. Estimate Fair Value: The sum of these discounted cash flows provides an estimate of the stock’s current fair value or intrinsic value.

Approach 2: Net Profit

1. Historical Growth Rate Determination: We calculate the historical net profit growth over the last 10, 7, 5, and 3 years and select the longest available period.
2. Growth Rate Cap: To ensure conservatism, we cap growth rates that exceed 20% per annum at 20%, acknowledging the challenge for businesses to maintain high growth rates for extended periods.
3. Projection of Net Profit: We project the current net profit per share over a 10-year horizon using the selected growth rate.
4. Terminal Value Calculation: We apply a terminal Price to Earnings (P/E) ratio of 15 to calculate the terminal value at the end of the 10-year period.
5. Discounting to Present Value: We discount both the projected net profit and the terminal value to the present day using a 12% discount rate.
6. Estimating Fair Value: The sum of these discounted values provides an estimate of the current fair value of the stock.

Discount to Fair Value Calculation

For both approaches, the Discount to Fair Value is calculated as:

(Fair Value Price – Current Stock Price) / Fair Value Price

Conclusion

The Discount to Fair Value metric provides a quantitative foundation for stock evaluation. However, it’s important to remember that past growth does not guarantee future performance, and investors may consider different terminal value ratios or discount rates for different stocks.

The fair value estimated by the Discount to Fair Value metric can be further validated with specific assumptions using the Intrinsic Value Calculator.